Question

Berk and DeMarzo (2020) exemplify the variances between the three key approaches companies utilize for capital budgeting with leverage and within imperfect markets. These approaches comprise the Weighted Average Cost of Capital (WACC) method, the Adjusted Present Value (APV) Method, and the Flow-to-Equity (FTE) Method.

The Weighted Average Cost of Capital method

WACC refers to a weighted average of the cost of debt, the cost of equity, and also the cost of preference shares. Importantly, these weights are the proportion of the capital amount obtained from every component, respective to the total market value (Hillier et al., 2019). Two key suppositions are made concerning WACC. First, it is assumed that the capital structure does not change. That it is supposed that the firms capital structure will continue to be the same in time. The second supposition that is made is that business risk does not change. It is assumed that business risk will prevail to be the same over time, even after the acceptance of a new project. From a realistic perspective, the risk will change when a firm experiences expansion or invests in a new market (Hillier et al., 2019).

Strengths

1. The WACC is a ratio that can apply to all new projects taken up by the company. It is reasonable for the company to accept or reject a project when a comparison is made concerning one unified cost of capital.

2. WACC enables a firm to make rapid decisions through the comparison of the profitability of the project with WACC. Due to the ease in its computation, the outcomes can be obtained in a minimal time.

3. Being the minimum return rate, the WACC can be utilized to replace the hurdle rate for some firms (Peterson and Fabozzi, 2002).

Weaknesses

1. WACC supposes that the firms capital structure will remain intact over time. Nonetheless, the capital structure is expected to change when a project is accepted. Since new projects can either be financed by equity or debt, it is anticipated that the WACC will change.

2. WACC computation always relies on the firms debt and equity ratio. Therefore, it becomes the distinctive WACC solely for this firm. It is significantly problematic to obtain a firm in a similar sector with a similar debt and equity ratio. For this reason, it isnt very worthy to compare the WACC of the firm to that of other firms (Peterson and Fabozzi, 2002).

The Adjusted Present Value method

The Adjusted Present Value (APV) method is used for capital budgeting and valuation of projects. This method takes into consideration the net present value (NPV), in addition to the present value of debt financing costs. These debt financing costs comprise financial subsidies, interest tax shields, as well as costs of debt issuance (Hillier et al., 2019). The adjusted present value (APV) approach initially values the project based on equity. The after-tax cash flows of the project under all-equity financing also referred to as unleveled cash flows, are positioned on the numerator section of the capital budgeting equation. What is positioned on the denominator section of the equation, assuming that the financing is fully provided through equity? After that, the net present value of the debt is added. In this case, the net present value of the debt is probably the summation of bankruptcy costs, tax effects, floatation expenses, and interest subsidies (Hillier et al., 2019).

Strengths

1. It encompasses a step-by-step approach and therefore renders a proper understanding of the components of the decision.

2. This approach can be utilized in evaluating any financing package

3. It is considered more straightforward than making an adjustment to the WACC, which can be significantly challenging and complicated (Peterson and Fabozzi, 2002).

Weaknesses

1. The method is based on Miller and Modiglianis tax theory. As a result, it overlooks agency costs, tax exhaustion, and bankruptcy risk.

2. The method is based on Miller and Modiglianis tax theory. As a result, it supposes that debt is risk-free and irredeemable (Peterson and Fabozzi, 2002).

The Flow-to-Equity method

The flow to equity method encompasses discounting the after-tax cash flow from a specific project to the levered firms shareholders. The levered cash flow refers to the residual to shareholders after the interest deduction. In this case, the discounting rate is the capital cost to the levered firms shareholders. Concerning a firm with leverage, the discount rate must be greater than the cost of capital for a firm unlevered (Hillier et al., 2019).

Strengths

1. This method can determine the strength of a companys financials and the firms earning potential.

2. The approach can play a significant role in identifying risks such as debt and liquidity levels.

3. Different from WACC, this approach facilitates comparative analysis both amongst companies and within industries (Fabozzi and Peterson, 2002).

Weaknesses

1. It is lengthier compared to other methods and necessitates extensive collection of data.

2. This approach accounts for dividends as deductions from the income generated instead of increasing income. Furthermore, this approach overlooks market value (Peterson and Fabozzi, 2002).

Question 2

Concerning financial management, it is financially prudent for firms to try to ensure that the managers interests align with the interests of the shareholders. Based on Berk and DeMarzo (2020), it was determined that there are numerous instances of agency conflict or conflict between management and owners of a company. There are different mechanisms that companies could utilize to facilitate the alignment of the interests of both the owners of the company and its managers.

Companies can implement an executive compensation policy. Three extensive principles should be taken into consideration for an executive compensation plan. First of all, the plan oght to e designed to guarantee the alignment of longstanding interests between the shareowners of the firm and the executive management. Secondly, the program should comprise a mixture of cash and equity compensation. Third, the compensation program should always be transparent (Seal, 2006).

In this case, the policy would guide directors and executives in granting rewards to important personnel. Financial rewards and incentives for industrious personnel should be stimulated. Nonetheless, the rewards should be based on performance. Some aspects that should be included in the compensation policy should include a properly outlined amalgamation of the managers base salary, bonus, longstanding incentive corporation, and equity ownership. The firms philosophy concerns the dilution of current shareowners through the dispersal of compensation-based equity allowances (Anson et al., 2004).

The second principle makes certain that management is involved in the game. This implies that a firms shareowner should be prudent regarding the firms costs and residual cash flows to the firms equity holders. By creating shareowners based on the executive management compensation plan, it is most probable that the managers will act and operate in the best interests because they are also new shareholders. This aspect will benefit all equity investors (Anson et al., 2004).

Lastly, it is important for the plan to be understandable and coherent. This implies that investors ought not to be compelled to decode or translate any aspect of the proxy statement to comprehend the compensation of major executives. Rather, it should e transparent and plain, and if the executives compensation is plenty of money, it needs to be well outlined (Seal, 2006).

Question 3

Scenario analysis alludes to the process of forecasting the future value of an investment contingent on changes that may occur to existent variables. It necessitates one...…and transaction expenses determine the companys payout policy (Jagannathan et al., 2018).

There is a misapprehension that share repurchases diminish the supply of shares and consequently set in motion increasing share prices. It is imperative to point out that when a company chooses to repurchase shares, two things take place. One, there is a reduction in the supply of shares; secondly, the value of the companys assets decreases owing to expenses incurred in purchasing the sales. These two aspects usually offset one another and the share price ends up remaining the same without being changed. This is akin to the dilution myth. When a company implements the issuance of new shares, the share price does not decrease because cash generated due to the issue causes an increase in the value of the assets (Wesson et al., 2018).

Question 8

One of the key aspects that Berk and DeMarzo (2020) highlight is that certain industries have a likelihood of firms utilizing more debt or leverage within their capital structures as contrasted against others. A significant variance in the debt-to-equity ratio amongst industries and between companies within an industry encompasses dissimilar capital intensity levels between the firms. Another reason is that the firms could have different natures of businesses, which causes having high debt levels simpler for management (Harris, 1994). It is imperative to note that capital-intensive companies necessitate substantial financial resources and massive amounts of money to produce commodities and services. A fitting example is firms operating within the telecommunications industry. These sorts of companies are usually forced to make significant investments in infrastructure, setting up miles and miles of cabling to render consumers the services they need. On top of such primary capital expenditure, extra capital outlays include essential maintenance, growth of service areas, and advancements (Ross, Westerfield, and Jaffe, 2005).

The second aspect that Berk and DeMarzo (2020) highlighted is that many firms have a tendency to underutilize debt, pushing the perspective that such firms are not acting in their best interest and failing to maximize firm value. On the other hand, there is the counterpoint that increased leverage levels result in greater financial distress, and by evading such financial distress, the companies are maximizing firm value. My perspective leans towards the latter argument. According to Novaes and Zingales (2003), debt causes an increase in efficiency owing to the reason that it precludes managers from ending up funding projects that are not profitable. Concurrently, it is imperative to point out that debt may preclude several profitable investment prospects. If financial distress expenses are significant, it is ideal for the manager to increase leverage beyond the value maximization level, intending to instigate an inefficient distress threat, making it much more challenging for any raider to pounce and increase value.

Zwibel (1996) makes the same argument indicating that a manager seeks to maximize their job occupation, which at any given time faces two threats, including a takeover or financial distress. Bearing this in mind, the managers optimal debt diminishes the likelihood of losing their job in the event of a takeover or financial distress. Unquestionably, the greater the debt is, the greater the probability of distress. Nonetheless, the manager might opt to increase leverage because debt decreases a raiders takeover motivations. Furthermore, it is pivotal to consider that if takeover costs are massive, a comparatively low debt level will diminish the managerial agency costs, causing the prospect of a takeover to be loss-making. In this regard, it is perceptible that the choice of debt may underlever the company concerning the debt level that shareholders would like to select in the lack of a takeover threat…